The so-called Bank of America settlement, in which the Charlotte bank is set to pay $8.5 billion (plus some additional expenses) to settle representation and warranty liability on 530 mortgage trusts representing $424 billion of par value, is being hailed as a possible template for other mortgage issuers and servicers.

I sure hope not, because some of the things I see in this deal look plenty troubling. Since this settlement has a lot of constituent elements and I want to cross check my reading with lawyers on this beat (I’ve been in contact with some, but they have not digested the documents fully either), I’ll simply flag a few high level issues.

The deal is not done. The settlement is actually between the trustee, Bank of New York, and Bank of America. The deal is subject to a so-called Article 77 proceeding. Objections are to be filed by October 31 and the hearing to approve the settlement is set for November 17.

The deal should be presumed to be favorable to Bank of America. Let’s just look at this from a game theory perspective. We’ve hectored Tom Miller for doing a bad job of representing his fellow state attorneys general in their mortgage negotiations for doing no investigation and therefore having no smoking gun and not much leverage. We have a different fact set and process but similar issues here. The investors had to overcome procedural issues even to be able to litigate. And MBIA, which is suing over similar issues but didn’t have the procedural impediments, is three years into litigation with Countrywide and is not very far along. This sort of case is a war of attrition and as a result, as we have indicated, even if the facts are lousy, there is reason to think that an eventual settlement would not be all that large even relative to the value of loans being disputed (the investors need to prove not only that the reps and warranties occurred, but that they led to losses. A lot of defaults, particularly post the subprime resets, are due to job losses and reductions in income. They can’t be blamed on failing to live up to the reps and warranties).

So with all these considerations arguing for fighting a few more rounds, and BofA in the past taking a very aggressive posture on disputing these cases, why would it settle?

The other side has no ability to judge what it might get since it has not gotten access to the loan files (the Clayton reports that everyone makes noise about which found pretty significant violations of representations, did not look at which were significant from a risk of loss perspective. So they may make for great headline, but they aren’t very helpful in this context.

Put it simply: BofA can judge what its risks are VASTLY better than the investors. There are a lot of reasons why it would make sense for BofA not to settle now. Yet it was all over this like a cheap suit. That says it must regard this settlement as a real bargain.

The investors are giving Bank of America a broader release than just of the rep and warranty claims. This looks like a “get out of liability free” care on chain of title issues. The critical bit is the release, which is section 9 (boldface ours):

Effective as of the Approval Date, except as set forth in Paragraph 10, the Trustee on behalf of itself and all Investors, the Covered Trusts, and/or any Persons claiming by, through, or on behalf of any of the Trustee, the Investors, or the Covered Trusts or under the Governing Agreements (collectively, the Trustee, Investors, Covered Trusts, and such Persons being defined together as the “Precluded Persons”), irrevocably and unconditionally grants a full, final, and complete release, waiver, and discharge of all alleged or actual claims, counterclaims, defenses, rights of setoff, rights of rescission, liens, disputes, liabilities, Losses, debts, costs, expenses, obligations, demands, claims for accountings or audits, alleged Events of Default, damages, rights, and causes of action of any kind or nature whatsoever, whether asserted or unasserted, known or unknown, suspected or unsuspected, fixed or contingent, in contract, tort, or otherwise, secured or unsecured, accrued or unaccrued, whether direct, derivative, or brought in any other capacity that the Precluded Persons may now or may hereafter have against any or all of the Bank of America Parties and/or Countrywide Parties arising out of or relating to (i) the origination, sale, or delivery of Mortgage Loans to the Covered Trusts, including the representations and warranties in connection with the origination, sale, or delivery of Mortgage Loans to the Covered Trusts or any alleged obligation of any Bank of America Party and/or Countrywide Party to repurchase or otherwise compensate the Covered Trusts for any MortgageLoan on the basis of any representations or warranties or otherwise or failure to cure any alleged breaches of representations and warranties, including all claims arising in any way from or under Section 2.03 (“Representations, Warranties and Covenants of the Sellers and Master Servicer”)1 of the Governing Agreements, (ii) the documentation of the Mortgage Loans held by the Covered Trusts (including the documents and instruments covered in Sections 2.01 (“Conveyance of Mortgage Loans”) and 2.02 (“Acceptance by the Trustee of the Mortgage Loans”) of the Governing Agreements and the Mortgage Files) including with respect to alleged defective, incomplete, or non-existent documentation, as well as issues arising out of or relating to recordation, title, assignment, or any other matter relating to legal enforceability of a Mortgage or Mortgage Note, and (iii) the servicing of the Mortgage Loans held by the Covered Trusts (including any claim relating to the timing of collection efforts or foreclosure efforts, loss mitigation, transfers to subservicers, Advances, Servicing Advances, or that servicing includes an obligation to take any action or provide any notice towards, or with respect to, the possible repurchase of Mortgage Loans by the Master Servicer, Seller, or any other Person), in all cases prior to or after the Approval Date (collectively, all such claims being defined as the “Trust Released Claims”).

Each of the three bolded sections is horrific.

Um, remember how we’ve been saying, and it appeared to have been confirmed by testimony in Kemp v. Countrywide, that all the notes were sitting with Countrywide when they were supposed to be with the trustee, and they were therefore almost certainly not endorsed as required by the pooling and servicing agreement? This looks like a way to shunt liability for this little problem.

The second bolded section gets Countrywide as originator out of any liability for chain of title issues.

The third bolded section would seem to allow Countrywide as servicer to shed liability for servicing abuses of all sort (there is qualifying language in section 10, but it does not seem to address the concerns I discuss here, but I welcome input and correction if warranted). All those impermissible fees to borrowers, such as junk fees, pyramiding fees, and overcharges, ultimately come out of the investors’ hides, since the borrowers go tits up and they payments ultimately are deducted from the proceeds of the sale of the house. And there are more obvious abuses of investors, like double dipping (charing fees to both investors and borrowers when only one should be charged) and servicers taking fees out of refi cash streams when they should only come from foreclosure proceeds.

As indicated, there is a good bit more here, but I wanted to stick to the biggest issue, which is the money versus the terms of the release. And the release looks to be far too broad and therefore a terrible deal to investors. This suggests the attorney may be savvy at getting deals hammered out and winning her fees but not at representing the real interests of her clients.

Update: This deal does not waive securities law claims but I don’t regard those as a major issue for Bank of America (the trustee is another matter), since the statute of limitations has passed as far as the origination of these deals is concerned. There is still liability on the ongoing representations made in annual filings on these RMBS (transactions with fewer than 50 investors can stop making those filings but virtually every deal made at least one annual filing).

There is also a longish discussion in paragraph 6 of how Bank of America is to prepare exception reports, and the bank is required to pay out 100% of any losses in cases where losses resulting from these errors is not covered by title insurance. Masaccio provides a good summary:

If a document is still on the revised exceptions list, with both a documentation error and a title insurance error, when an RMBS tries to foreclose, and if the RMBS is unable to foreclose because of documentation errors, and if no insurance is available, then BAC has to pay the entire loss.

The reason I don’t regard this language as all that helpful to investors is that despite its length, it actually fails to address the overwhelming majority of standing challenges:

The Initial Exceptions Report Schedule shall be prepared in good faith, after reasonable diligence, and shall include each Mortgage Loan in the Covered Trusts (including, for the avoidance of doubt, Mortgage Loans for which the servicing rights are sold following the Signing Date) that, on the Trustee’s Loan-Level Exception Reports (as defined below), is subject to both(A) a document exception relating to mortgages coded “photocopy” (CO), “copy with recording information” (CR), “document missing” (DM), “county recorded copy with comments” (IN), “certified copy not recorded” (NR), “original with comments” (OO), “unrecorded original” (OX), “pool review pending” (PR), “contract” (CONT), and “certified copy-issuer” (CI) on the Trustee’s Loan-Level Exception Reports, (“Mortgage Exceptions”) and (B) a document exception relating to title policies or their legal equivalent coded “document missing” (DM), “title commitment” (CM), or “preliminary title report” (PL) on the Trustee’s Loan-Level Exception Reports, (“Title Policy Exceptions”), provided that it shall exclude any such Mortgage Loan registered on the Mortgage Electronic Registration Systems (“MERS”). Mortgage Loans paid in full or liquidated as of the Signing Date shall not be included in the Initial Exceptions Report Schedule.

This thus precludes MERS and local recording issues (note our post earlier today with adverse decisions in Oregon), failures to have complete chain of title, efforts to transfer the note into the trust after the cutoff date in the PSA, etc. There is no requirement to see whether the notes and assignments comply with the requirements of the PSAs.

As masaccio notes: “The settlement is based on the theory that documentation errors can be cured at this late date.” A significant and growing number of judges have rejected that theory. Yet the broad release dumps the risk of judges taking the errors and misrepresentations made by the originators and servicers seriously and rejecting foreclosure actions on the investors when it should properly sit with the parties that created this mess.

In addition to masaccio’s, two other useful overview posts come from Adam Levitin and D&O Diary (hat tip Arthur).

Why would investors buy into these deals in the first place? I mean if the deal basically says “we might be deliberately passing you bum loans in these securities, but to prove it you’d need to see the loan files, so we get to hide them from you,” that sounds like something to walk away from.

I can’t understand the passivity of investors as this major fraud unfolds. Because BofA never transferred the loans into the trust, investors were sold worthless securities. And they will now settle for pennies on the dollar? Are they being made whole by the government somehow on the sly? Because it seems to me that the investors could pound BofA into the ground like a tent stake.

The problem is one of agency, as the “investors” are actually pension fund managers. The managers don’t care how well the fund does, as they probably get kickbacks from the sell side for buying crap investments. And if they get caught, they can always eject and go work for the sell side.

Wasn’t Tom Miller bribed? I read the internet and came to this conclusion. Also, unrepentant bank officers should be dealt with by placing them into “foreclosure” i.e. receivership. (This too, I read on the wacky world wide web.)

RICO ??? When did the Bush Administration revoke the RICO civil suit law ?

This was mortgage brokers, bribed faux-appraisers, bribed faux-rating agencies (tagging a fresh new 1,500 no-diligence “AAA” rated Prime issues), and BofA and other bank-perps. How is this not a RICO-eligible action ???

I also don’t quite follow this. If the borrower loses their job, they weren’t a good prospect and representing them as such would still be a reps & warranties breach.

Simply verifying the income of each borrower was a fraction of what was on the application would be damning enough for this whole thing to go against the banks. But I don’t expect anyone to want to work enough to connect the dots, especially since the pension fund managers who bought into this dreck are buddy-buddy with the banksters who sold it to them. Significant push-back might cancel their meal ticket.

I’m not telling you my personal sentiments, I’m telling you how this would be adjudicated if a case got that far. You may not like the fact that the originators aren’t liable in putback cases for losses due to unemployment (after all, it was the banks that tanked the economy and led to the job losses), but it’s a legitimate defense and they are just about certain to carry the day with that argument on the loans where that is applicable.

Any lending in theory contemplates a certain amount of losses (in theory, we know everybody got high before the crisis and did really stupid stuff, but “stupid” is usually not recoverable in a court of law). That’s why their yield is higher than Treasuries. It’s called a risk/return tradeoff. The lender charges a higher yield to cover for expected losses and for his costs in making the assessment of those expected losses.

So in these putback cases. let’s say the judge agrees to sampling. They pick a certain number of loans. as representative, say 2000. The plaintiff says: See, of these 2000 loans, 600 didn’t meet the underwriting standards, so we should be able to put them back.

The defense will argue of that 600, 100 had rep breaches that were trivial and didn’t really affect the quality of the loan, and of the remaining 500, 250 were due to job loss and hours reduction (“shit happens”) and thus don’t count.

In other words, the plaintiff has to prove BOTH that the reps and warranties were breached AND those breaches led DIRECTLY to losses.

Or look at the same issue another way. let’s consider a hypothetical conversation. Countrywide calls the risk manager for one of the investors to the stand:

Laywer: You were in charge of risk management during 2006 and 2007, is that correct?

RM: Yes

Lawyer: Did that include the development and use of models to estimate losses on subprime loan pools and bonds?

RM: [Some detail about nature of job and who did what, but answer is effectively yes]

Laywer: What was the worst case scenario that you modeled for housing price declines and unemployment?

RM: [After much hemming and hawing] Housing prices flat and unemployment at 6.5%

Lawyer: What level of losses do you think your model would have shown with unemployment at 10% and housing prices falling 25-45%, with the most severe declines in the biggest markets?

You are still missing the point. Go back to my argument by the bank that 250 loans of the 600 misrepresented went bad due to the fact that the person lost their job.

If the borrower was current prior to the job loss and fell behind afterwards, it is IRRELEVANT whether there was a rep breach as far as this sort of case was concerned. The loss did not result from the loan being misrepresented, it resulted from job loss.

Your hypothetical conversation does not address the issue. Mine does on a broader basis.

I’m not saying I like this, mind you. I’m just saying this is how this will play out if the case ever got this far (and believe me, it would not, these cases are too costly to bring to trial).

But this should illustrate the difficulty of proving and winning these cases, and thus why pretty much no one (save the monolines, who are kept going based on the recoveries they might get from these cases) has pursued them in a serious way.

In my hypothetical situation above, let’s say the janitor was qualified at his real, not fake, income of $50K at a 35DTI, not $150K at a 35DTI.

Would a job loss necessarily cause him to default? Maybe he collects unemployment benefits and has enough cushion to make the payments. Maybe, because he really had a 35DTI, he was able to build up reserves and pay out of those.

On the other hand, paying a mortgage when qualified at $150K but actually making $50K puts you in tremendous financial stress to begin with, and much less likely to pay through a job loss.

So it is inherently untrue that a job loss causes default in every situation, and equally untrue that a job loss is always the sole contributing factor in a default. Many people lose jobs and still make their mortgage payments, and many people default while still holding jobs (and some even get a mortgage without ever holding a job).

It is extremely difficult to prove one way or another what causes a default. Was it the job loss, or the fact that the originator put the borrower in a situation where he was stretched so thin that he couldn’t survive any financial shock, a situation that was hidden from the investor? The rep breach is not IRRELEVANT (to use your assertive all-caps).

You assertion that job loss caused default and thus cannot be challenged is just that, an assertion, it’s not proof.

I’m seen as a blogger, not a financial services professional/expert. I could be a dog or 16 years old :-)

In all seriousness, the issue (for the investors who aren’t part of the camp that would be delighted to see the mortgage paperwork mess buried, like the NY Fed and probably Fannie (Treasury) and Goldman, the issue is that they have assumed their lawyer is working for them. She tells them this is a really good deal. They have general counsels who aren’t litigators and aren’t up on how this chain of title stuff is playing out in courts (and that BTW is a cutting edge area of the law right now, only a few boutiques specialize in structured credit litigation, and the law firm representing the investors isn’t one of them, it’s a litigation boutique). The fund manager might be up to speed on some of the court issues, since that does affect the value of these bonds, but more likely not, and even if they were pretty conversant, I doubt any of them have been asked to review the language of the release either (in a smaller shop or hedge fund that would probably happen, but I doubt it would take place in a larger firm)

So they aren’t in a position to assess what is really being traded for the settlement payment and it wouldn’t occur to them to get an independent reading (it’s not common to second guess your counsel by getting an opinion from another attorney or independent expert).

Maam;
Re the settlement ‘protocol;’ Wouldn’t the firms involved be going through some serious stress driven internal power struggles? If so, it would only be prudent for some of the actors involved to bring in ‘hired guns’ to look for advantages arising out of the settlement process. I find it hard to conceive of a responsible manager not getting a backstop position ready. Am I being naif? (Seriously, you deal with these people, I don’t.)

This deal is incredibly favorable to BofA. So the lawyer was basically selling out her side to get a fee. They didn’t figure that out, or didn’t care (as in they thought they’d never litigate these issues) or had the same motives as BofA (to make this mortgage mess seem less of a big deal).

Well this should be interesting. So BofA gives the investors a token to keep them quiet. Now, how about that title problem. How are they going to reconvey all those loans that were actually transferred, as I am sure that some were, back to BofA. I am running out of popcorn watching this show. Thank you Yves for addressing the elephant in the room..the Note. Try as they may, they can’t fix that problem. This will take decades to sort out, decades. Every time they attempt a ‘fix’ it just makes it more complicated and adds a few more years to un-complicate it.

As I understand it though if chain of title was not done properly in the beginning there is no trust under NY law thus technically the trusts that are settling with BofA/Countrywide don’t really exist.

You are correct if NO notes got to the trust by closing, you have a contract formation failure. And given the testimony in the Kemp v. Countrywide case, that Countrywide kept the notes, that may well be the case for quite a few trusts.

But no one wants to fight a case on that basis. It would blow up the mortgage industrial complex.

So we are in Tinkerbell land, everyone pretends if we all clap hard enough, Tinkerbell lives.

No-one? You’d think there were some MBS investors who have no vested interest in keeping the mortgage-industrial complex going: big money men who own their houses outright and have now divested of financial stocks. Who would get their money back from the fraudulent MBS….

Excellent post, Yves. Great work in parsing through the details of the proposed settlement.

It occurs to me that if the banks can get releases on putback claims, it may affect their conduct of foreclosure litigation. Might we see depositors or other current note holders (not the trusts) stepping forward to initiate foreclosures as the rightful holder of the beneficial interest in the mortgage?

This is all just the tip of the arguement. The public is waking up to the con game of banking in general. According to federal charter, banks are not able to loan it’s own money for the loan to begin with. The fireworks are circling the globe.The head of the IMF is dethroned, the private owners of the not federal, no reserves, Federal Reserve are underground. Watch as the dinar bandaid comes to the rescue, and who is there in this select group of banks to help the currency to be cashed in? My, my it is B of A. It is also the last bandaid in the box before the crash.

Not intending to be critical, Yves, rather more broadly thinking about the context in which this settlement occurs … I am wondering if any of this fallout from ’08 will matter over coming weeks were, say, the EMU to collapse ( …or “insert systemic risk here” … as lord knows there are several). In other words, what foreboding precedent might be set by this unjustly generous settlement you suspect were BofA otherwise on the verge of being swept away?

Great article! The one thing I would clarify is your statement in the fourth paragraph that, “the investors need to prove not only that the reps and warranties occurred, but that they led to losses. A lot of defaults, particularly post the subprime resets, are due to job losses and reductions in income. They can’t be blamed on failing to live up to the reps and warranties.”

Though the banks have repeated the mantra ad naseum in public comments that investors must prove that breaches actually caused a default, there is actually no such standard in most pooling and servicing agreements, and this argument has never been made with a straight face in any of the major RMBS litigation. Instead, the standard is that the breach must have “materially adversely impacted” either the value of the loan or investors’ interest therein. This material impact can be shown by evidence that arrangers paid less for loans that exhibited these types of deficiencies.

Thus, instead of showing that a breach was the reason the loan defaulted, investors must only show the breach made the loan riskier and therefore less valuable. This is because reps and warranties are designed to be measurable at the outset of securitization. They deal only with the process undertaken from origination to sale of the loans, and do not depend on why the loan eventually defaults (or even if it defaults – current loans can be put back, too).

On the other hand, some reps and warranties deal only with whether the loan has already defaulted, such as the prohibition against early payment defaults. That is, if a loan goes down within 90 days, it’s a breach. It would be nonsensical to ask whether the EPD caused the default – the default itself constituted the breach. Thus, sellers often repurchase EPDs without hesitation.

This difference between a causation and a materiality standard is important to understand, because it shows that proving breaches of reps and warranties is not so difficult, once loan files are in hand.

“According to the amended complaint, Countrywide Home originated or acquired residential mortgages, selected certain of those loans for securitization and transferred them into Countrywide-created trusts that issued the notes. Either Countrywide Home or Countrywide Servicing acted as the servicer for the mortgage loans. Countrywide Securities underwrote the securitizations and sold the securities to investors.”

“These allegations are sufficient to show loss causation since it was foreseeable that MBIA would suffer losses as a result of relying on Countrywide’s alleged misrepresentations about the mortgage loans”